6/10/2010 @ 6:00AM

Junk Bonds: Are Worse Days Ahead?

If you had the intestinal fortitude to buy high-yield bonds at the height of the financial crisis, you’re sitting pretty these days. At the depths of economic despair in late 2008 junk bonds were yielding 20 percentage points more than Treasuries, a yield spread that would have made sense only if the rate of corporate defaults was destined to rise to double its rate during the Great Depression. Investors who bought junk back then and have hung on during the past 18 months have reaped total returns of 50% or more. That’s despite the losses that junk bonds, along with stocks, have suffered this spring.

But suppose you missed the 2009 buying opportunity. Should you take advantage of the recent pullback in junk bond prices? Should you be putting cash into this market segment now?

Probably not, says Edward Altman, a finance professor at New York University’s Stern School of Business and creator of the Altman Z-score, a widely used measure of bankruptcy risk.

“Spreads should be higher. I’ve been saying that for a couple of months now,” Altman says. “The risks seem to be quite substantial, both in the short term and several years down the line.”

One possibility to consider is that Europe’s sovereign debt crisis could jump the Atlantic and lead to a double-dip recession, as well as a spike in corporate defaults, including among junk bond issuers. (The 12-month trailing default rate briefly hit a post-World War II high of 13% last November before retreating.) Also overhanging the market is a trillion-dollar wave of refinancings for high-yield debt, leveraged loans and commercial real estate–$400 billion worth in 2012 and $600 billion in 2013, Altman figures.

That big number by itself isn’t too unusual or disconcerting, but if it were combined with another credit crunch it’s an entirely different matter, says Albert Metz, managing director for credit policy research at
Moody’s
.

“If liquidity dries up, then you really have a problem,” Metz says.

A third cause for concern is how junk bond issuers and investment bankers have been watering down bond issuance covenants of late. Historically borrowers rated BB or lower have pledged specific assets to back their borrowings. That way, investors were left with something if a debtor got into trouble. That’s not always the case with high-yield issuers anymore.

“It’s odd that what’s happening now, after the last two years, is a weaker set of covenants than at the peak of the market,” says Moody’s covenant analyst Alexander Dill.

Dill has issued pre-bond-sale reports in the past month about covenant-light tactics employed by the likes of
AK Steel Holding Corp.
, home builder
Lennar Corp.
and fertilizer giant
CF Industries Holdings
. Debt covenants for AK Steel’s $400 million Ba3-rated debt, issued this April, “are significantly less protective than in its previous issuance” in 2002, Dill wrote in a recent report.

What’s a junk bond investor to take away from all this? Caution would be a good start.

“If you’re investing in a high-yield bond fund and assume there’s protection against this sort of thing, think again,” warns Dill of issuers’ covenant craftiness. “People want to be optimistic, and they’re just not looking at what just happened. It’s remarkable.”

The GDP watchers at the National Bureau of Economic Research are busy sparring over whether the recession has ended. Either way, corporate borrowers are by no means out of dangerous territory. For a ranking of financially risky companies, see the latest edition of the Forbes Risk List atwww.forbes.com/distress.

The one good thing about high-yield corporate bonds is that they are less prone to damage from rising interest rates than U.S. Treasury bonds of similar maturity. If you go into this sector, do so with your eyes open. Buy a fund, not individual bonds, since bid/ask spreads are wide and those covenants are tricky to evaluate. Hold the fund in a tax-deferred account. Finally, be prepared for volatility.

High Risk, High Return

Bond investors get paid for taking on risk. But with economic fears rising, rewards for bonds like these may soon seem paltry.

Junk Ride

In a world where Treasury bonds are flirting with record-low yields, investors are understandably attracted to high-yield debt. The funds below offer a low-cost, efficient way to hop aboard-but be ready for some bumps along the way.

Performance

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Up Mkt

Down Mkt

Fund

Total Return

5-Year Annualized

Yield

Assets 4/30/10 ($Mil)

Average Duration (Years)

Annual Expenses

per $100

Minimum

Initial

Investment

B

C

Fidelity High Income

8.2%

6.6%

$7,429

NA

$0.75

$2,500

D

B

Northern High Yield Fixed Inc

6.1

8.6

3,097

4.8

0.90

2,500

C

A

T Rowe Price High Yield

7.6

7.3

7,660

3.4

0.80

2,500

D

B

Vanguard High-Yield Corp-Inv

6.0

7.4

12,076

4.6

0.32*

3,000

C

B

Wells Fargo High Income-Inv

6.4

7.2

633

4.5

0.95

2,500

Performance through Apr. 30. *Distributor may impose redemption fee on shares held less than one year. NA: Not available.